Allocation of Resources · 4 question types
Past paper frequency (2018 to 2024)
This topic accounts for approximately 16% of your exam marks.
Equilibrium price, surplus/shortage, and price mechanism analysis are core Section B content; tested in most Paper 2 sittings.
The price mechanism is the system by which prices, set by demand and supply, allocate scarce resources in a market economy. Prices do three distinct jobs.
The signalling function: prices act as signals that tell producers and consumers how relatively scarce a good is, and how much it is wanted.
A rising price signals scarcity (or rising demand). Producers see it and switch resources toward that good; consumers see it and consider whether to substitute away.
A falling price signals abundance (or falling demand). Producers move resources elsewhere; consumers find more affordable options.
Example — when oil prices spike, the rising price signals to oil firms to drill more, and signals to consumers to consider electric cars or public transport. No government order is needed.
The incentive function: prices give producers and consumers a reason to change their behaviour. A high price rewards producers who supply more and punishes consumers who buy.
Two parts to the incentive:
The incentive function is the engine that turns the price signal into actual changes in production and consumption.
The rationing function: prices ration scarce goods to those who are willing and able to pay. When supply is limited, the price rises until only consumers who value the good enough to pay are still buying.
Example — concert tickets for a popular band sell out within minutes at their initial price. Resale prices then rise to many times face value. The high resale price rations the limited supply to fans willing and able to pay the most. The market mechanism allocates the scarce tickets without any central body deciding who deserves them.
The three functions work together to answer the three big questions an economy faces (introduced in topic 1).
| Big question | Function of the price mechanism that answers it |
|---|---|
| What to produce? | Signalling: high prices show what consumers want; producers respond. |
| How to produce? | Incentive: high input prices push firms to find cheaper methods. |
| For whom to produce? | Rationing: the goods go to those willing and able to pay the equilibrium price. |
Together, these three functions are the reason a market economy can allocate millions of scarce resources without central planning.